Value of Control

When valuing a firm, you always need to consider the competence and strengths of the management of the firm. With private firms, where the owner is also the manager, this consideration carries special weight, since the owner has absolute control. In contrast, in a publicly traded firm, incompetent management can often be replaced, if enough stockholders can be convinced that it is in their best interests to do so.

There are implications for valuation, if a portion of a private firm is offered for sale. If that portion provides a controlling interest, i.e, the right to pick the firm’s management, it should have a substantially higher value than if it does not provide this power. Normally, this would mean that 51% of a private firm’s equity should trade at a substantial premium over 49%. This applies whether a firm is being sold to a private entity or a publicly traded firm, and may arise in an initial public offering. If, for instance, only non-voting shares or shares with diluted voting rights are offered to investors in the public offering, they should trade at a discount on shares with full voting rights.

While the intuition about the value of control is simple, estimating how much it is worth is a little more difficult. We will defer a full discussion of the topic until we get to the chapter on acquisitions, but we will value it as the difference between two values – the value of the firm run optimally and the value of the firm with the incumbent management. For instance, if the value of a private firm run by incumbent management is $100 million and the value of the firm run optimally is $150 million, the difference in values between the 51% and 49% shares can be computed.

Value of controlling interest = 51% of Optimal Value = 0.51* 150 = $ 76.5 million

Value of non-controlling interest = 49% of Status Quo Value = 0.49 * 100 = $ 49 million

The additional 2% interest (from 49% to 51%) has a disproportionate effect on value because of control. This value of control will be greatest for private firms that are poorly run and will be close to zero for well run firms.

In fact, the same approach can be used to compute the discount that non-voting shares will trade at, relative to voting shares in initial public offerings. For instance, assume that the private firm described above creates 10 million voting shares and offers 70% to the public. Since the potential for changing management is created by this offering, the value per share will fall between $10 and $15, depending upon the probability that is attached to the management change. Thus, if the probability of the management change is 60%, the value per share will be $13.00.

Value/Shr

Now assume that this firm had issued 9 million non-voting shares, with management retaining 1 million voting shares with complete control. In this case, the non-voting shares will get little or none of the estimated value change from optimal management. In fact, the values of the two classes can be estimated.

Value: non-voting share

Value per voting share =

The voting shares in this case would trade at an enormous premium over the non-voting shares, but that is because we have assumed that the probability of change is still 60%. If the incumbent managers are much more likely to fight a change in management, this probability will drop and reduce the premium with it.